On April 23, the UK Financial Conduct Authority (FCA) published a report on payment for order flow (PFOF).
The report provides an update on the FCA’s supervisory work on conflicts of interest and PFOF, and it follows the FCA’s preliminary findings that were published in issue 56 of its Market Watch newsletter (as reported in the September 28, 2018 edition of Corporate & Financial Weekly Digest).
PFOF occurs when an investment firm (usually a broker) that sources liquidity and executes orders for its clients receives a fee or commission from the client originating the order and the counterparty with whom the trade is subsequently executed (typically a market maker or other liquidity provider). PFOF payments create a conflict of interest between the firm and its clients because they incentivize the firm to execute clients’ orders with counterparties based on the latter’s willingness to pay commissions. PFOF therefore makes it more likely for extra costs to be passed on to the broker’s client, through wider bid-ask spreads from market makers and other liquidity providers who agree to pay PFOF to attract order flow from brokers.
Through its supervisory work and assessment of firms’ systems and controls monitoring effective compliance, the FCA found a distinction between broking activities that source exclusive liquidity for a specific client and those that provide non-exclusive liquidity to a range of counterparties. In particular, the FCA found that:
- the majority of firms have stopped charging liquidity providers when sourcing exclusive liquidity for a specific client, regardless of client classification;
- it has been difficult for firms to be certain if their activity was legitimately providing non-exclusive liquidity to a range of counterparties, which may allow them to manage the conflicts of charging both sides of a trade;
- firms could do more to improve the systems and controls they use to manage conflicts of interest for specific areas of their business; and
- firms sometimes routed client orders to overseas affiliates that charged liquidity providers PFOF.
A webpage published alongside the report states that firms should read the report and consider how to improve their practices, policies, systems and controls to meet their obligations. The FCA adds that its supervisory work will continue to prioritize and monitor compliance with conflicts of interest rules and PFOF, and that it will consider using its full range of powers, including enforcement action, to penalize firms breaching its rules.